Court throws out SEC hedge fund rule

SEC will consider other ways of regulating hedge funds, chairman says

AlistairBarr

WASHINGTON (MarketWatch) -- A federal court on Friday threw out a rule requiring hedge fund advisers to register with regulators as investment advisers, sending the U.S. Securities and Exchange Commission back to the drawing board to design new oversight guidelines.

The U.S. Court of Appeals for the District of Columbia Circuit called the SEC rule "arbitrary" because it exempts funds with 100 or fewer investors from Investment Company Act regulations but compels registration for those with 15 or more investors under another act.

SEC Chairman Christopher Cox said the agency will now re-evaluate its approach to hedge fund regulation and consider alternatives.

Cox's predecessor at the SEC, William Donaldson, had pressed hard to get the rule in place and argued for stricter oversight of hedge funds.

"This is a tremendous blow to the SEC," said Mitchell Nichter, an attorney with law firm Paul Hastings Janofsky & Walker.

"It's not about tweaking or revising something, they're back to square one and will have to come up with a completely new theory as to how they're going to regulate hedge fund advisors," said Douglas Hirsch, a partner at Sadis & Goldberg, a law firm that represents several hundred hedge funds and has helped more than 50 managers register with the agency.

The suit was brought against the SEC late in 2004 by Pleasantville, N.Y.-headquartered Opportunity Partners, an activist hedge fund firm run by Phillip Goldstein. See full story.

Hedge funds have traditionally been lightly regulated investment partnerships for rich investors and institutions, but the industry has grown rapidly in recent years and there are now an estimated 8,000 funds overseeing more than $1 trillion. That growth encouraged the SEC to introduce a new rule last year that required hedge fund advisers to register with the agency as investment advisers.

Under the rule, all hedge funds with more than 14 investors and $25 million in assets had to register by early 2005. The new regulation also entailed hiring a compliance officer, submitting to SEC inspections and meeting a series of other record-keeping requirements.

"I'm still trying to digest it all, but it looks like a pretty complete victory," Goldstein said in an interview, adding that it's up to Congress, not the nation's securities regulator, to regulate hedge funds.

"The SEC wanted to bring hedge funds under its wing," Goldstein said. "They couldn't do that ... because the law specifically excluded hedge funds from registering. So they tried to figure out a way to get around the law."

Client definition

Since 1985, the SEC had defined the client of a hedge fund advisor as the fund that the manager ran, not the individual investors who put their money into the entity.

That meant that most hedge fund managers were exempt from registering as investment advisors because they ran fewer than 15 funds.

But last year, the SEC reversed that position: clients were now defined as the individual investors. That change forced many hedge funds to register.

The court decided on Friday that the SEC didn't come up with a good enough reason for changing that definition.

"It's a very tough opinion from the SEC's standpoint," Barry Barbash, a partner at Willkie Farr & Gallagher and former director of the agency's Division of Investment Management. " It can't be characterized as anything but a total loss."

De-registering

Some large hedge fund firms used a loophole to avoid registering last year, but thousands of managers did sign up.

Nichter said he expected that a "substantial number" of those hedge fund managers will try to de-register from the SEC.

Still, many institutional hedge fund investors may have already become used to their managers registering as investment advisors, said Ron Geffner, a partner at Sadis & Goldberg and former SEC enforcement attorney.

"Institutional investors have gotten a taste for some degree of regulation and transparency and that may force some hedge fund advisors to stay registered," Geffner explained. "But it's safe to assume that some hedge fund advisors will withdraw their registration."

'Vindicated'

The SEC's hedge fund rule was controversial from the moment it was first proposed under William Donaldson's stint as chairman of the agency.

Two Republican commissioners, Cynthia Glassman and Paul Atkins, voted against the rule, which squeezed through with the support of Donaldson, Roel Campos and Harvey Goldschmidt.

Glassman, who decided to leave the SEC in May, was a vocal critic of the rules, arguing that they would increase costs and add other burdens without reducing hedge fund fraud. See full story.

The SEC was also criticized for pushing through the new rules too quickly and ignoring input from critics.

On Friday, Chairman Cox alluded to that, saying the agency would use the court decision "as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors, maintain fair and orderly markets, and promote capital formation."

The hedge fund rule is the second major SEC initiative to have been thwarted by the courts recently.

A rule requiring mutual fund boards to have independent chairmen and directors was handed back to the SEC in April after a federal court decided that the agency didn't allow enough comment on the estimated costs of the regulation.

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